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In a recent article discussing the range of possible credit scores, I highlighted the relationship between credit and mortgage interest rates. This article will provide additional examples to demonstrate the importance of credit scores in our modern economy.
As a reminder, your credit score is a three-digit number created by credit scoring agencies like FICO. These companies use algorithms to analyze your credit report(s) and automatically generate your credit score(s).
Businesses use your credit as a proxy for trustworthiness, which means that your credit score plays an important role in all of the financial situations discussed below.
Good Credit and Home Mortgage Loans
If you are looking secure a mortgage to purchase a home, there are two important credit requirements that you should understand. You must first have a sufficient credit score to qualify for a mortgage. If you do qualify, your credit score determines the loan interest rate.
Government-sponsored FHA loans require a minimum credit score of 500 to qualify, but you must submit a 10% down payment if your credit score is between 500 and 580. If your score is above 580, the required down payment is 3.5% of the loan amount.
To qualify for any standard, non-governmental mortgage, you typically need a credit score of 620 or higher. If you qualify, your credit profile largely determines the loan interest rate. The table below was created using the official FICO loan calculator to highlight the correlation between credit scores and loan interest rates (assuming a $200,000, fixed 30-year mortgage).
|FICO Score||APR||Monthly |
|Total Interest |
The “Credit Penalty” column is the difference in total interest paid between the comparison group and the excellent credit (760+) group. Notice how large the penalty can be over 30 years.
Most banks will review other financial factors in addition to your credit score (income, existing debt, etc.) when evaluating your loan application, but the comparison above holds all of those factors equal. In other words, the table is comparing two individuals with similar financial circumstances but different credit scores.
With credit playing such an important role in determining the interest rate on any loan, every potential homeowner should nurture their credit to ensure the lowest possible interest rate.
Good Credit and Auto Loans
The discussion above also applies to automobile loans, where the loan interest rate largely depends on your credit score.
To illustrate, I’ve created another table summarizing how credit scores impact 60-month auto loan rates (assuming a $20,000 loan balance).
|FICO Score||APR||Monthly Payment||Total Interest Paid||Credit Penalty|
Here you can see that most lenders use a slightly different FICO scale for auto loans. Because auto loans require less capital than home loans, lenders are willing to accept more risk and provide loans to less qualified applicants. It’s also possible to qualify for the best rates with a lower credit score (720 vs 760).
As was the case with home loans, there are massive credit penalties at stake. You will pay thousands of dollars in unnecessary interest with anything less than excellent credit.
Perhaps you are interested in obtaining a loan to start a business.
Or, you might apply for a personal loan to consolidate credit card debt.
Or, you might be interested in refinancing your student loans to reduce the interest rate and required minimum monthly payment.
I’m not going to recreate additional rate tables for every potential loan category, but the demonstrated relationship between credit and interest always holds true. You will always pay fewer fees and less interest if you maintain an excellent credit score.
Good Credit and Credit Cards
The interest rates charged by credit cards are also determined by your credit, but that shouldn’t matter. Even with perfect credit, the interest rates are ridiculous and you should try to avoid carrying any type of debt balance on any credit card.
The one exception to that rule is 0% balance transfers. Because credit card debt is so profitable, many issuing banks will allow you to transfer your existing credit card debt to a new credit card and receive 0% interest for up to 24 months.
But all credit card approvals, including balance transfers, are determined by your credit. To qualify for any balance transfer credit card you will need a credit score of roughly 675 or higher, and the best cards often require a credit score above 700. This is true for cash back and rewards credit cards too.
Good Credit and Insurance Premiums
To establish eligibility and help determine insurance rates, most U.S. insurance companies now include your credit information as a potential risk factor (except in Massachusetts, Hawaii, and California, which ban the use of credit in risk underwriting).
For example, in auto insurance, your credit information is used alongside your driving history, claims history, vehicle information, and location to determine your overall risk profile. Home, renters, and other types of insurance use similar methods.
Research has shown that credit scores accurately predict future accident potential. Individuals with higher credit scores tend to get into fewer accidents and cost insurance companies less money than their lower-scoring counterparts. In 2003, The University of Texas conducted an analysis using 175,647 auto insurance policies. They found that individuals with poor credit scores incurred higher losses and were more likely to be involved in accidents. In 2007, The Federal Trade Commission found that credit-based insurance scores are effective predictors of risk, supporting earlier research.
In light of these findings, most insurers consider your credit when setting monthly premiums. Consumer Reports released a study showing that poor credit can double or triple your monthly auto insurance premium (compared to excellent credit). InsuranceQuotes found that homeowners with poor credit pay 91% more for coverage than homeowners with excellent credit.
Rental Agreements and Utility Deposits
If you are looking to rent a home or apartment, most landlords now request your credit as part of the process. They are looking for any signs of trouble, including any type of delinquent or late payments on your credit report.
If you have a credit score below 625 and/or a history of missed payments, many landlords will deny your rental application. Even if you are approved, most will require a large upfront deposit or advanced rent payments.
Many cellular providers and utility companies have a similar process. With a poor credit score and/or a history of missed payments, your request for service may be denied. At the very least, most providers will require an upfront deposit to insure against any potential payment problems.
Potential employers often request your credit during the hiring process. Most companies aren’t interested in your credit score, but they are interested in your credit report.
The information in your credit report is used as a proxy for your character. Many companies believe that a history of poor credit decisions is indicative of future employee performance.
Whether you agree or disagree doesn’t really matter, because legally, companies are allowed to use this information when hiring new employees.
Yes, A Good (or Bad) Credit Score Matters
I’ve seen a few other websites implying that your credit is unimportant. Nothing is further from the truth.
The vast majority of Americans will obtain several loans and credit cards over time. Both decisions are heavily credit-dependent, and poor credit often means thousands of dollars wasted on unnecessary interest payments.
Beyond determining loan interest rates, your credit plays a key role in insurance underwriting, rental agreements, utility deposits, and potential employment opportunities.
In our modern economy, your credit profile matters more than ever before.